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Importance of FX markets
- FX markets required for smooth functioning of international trade & transferring savings between countries
- International capital markets transfer funds from surplus countries → deficit countries
- Value of one currency relative to another currency
FX markets - important history
- 1944 - Bretton Woods = fixed exchange rates pegged against the US$ which was pegged against gold
- 1973 - changed to floating (due to change trade patterns, economic growth)
Fixed Exchange Rates
- Value of currency determined by government or central bank.
- Demand/supply of currency usually not in balance under this system, so govt has to use reserves if demand for foreign currency is greater than supply
Fixed Exchange Rates - 1. "If too much pressure on overseas currency reserves..."
Govt may be forced to devalue/put severe restrictions on movement of funds.
Fixed Exchange Rates - 2. "If FC supply > demand..."
Reduction may be necessary if the government begins to hold too many reserves.
Floating Exchange Rates
- An exchange rate is determined by supply and demand factors in the FX market
- NZD floated March 1985
If demand for $ increases, currency appreciates. If demand decreases, currency depreciates
- Foreign exchange dealers and brokers
- Central banks
- Firms conducting intl trade transactions
- Investors/Borrowers in intl money &/or capital market
- Foreign Currency speculators
FX Markets - Location
Global telecommunications network between major financial centres i.e. large banks - largest OTC market in NZ & globally
FX Markets - Trading hours
Around the clock, NZ niche time- after LA closes & before Sydney opens
FX Markets - Most active centres
UK most active FX centre 34.1%, US 19%, Japan 8%
FX Markets - Deepest volume @...
Deepest volume around midnight when NY & Europe trading ⇒ lowest bid-ask spreads
FX Markets - Volume
Global transactions averaged US $5.3T billion per day April 2013 with 1.5T spot FX
FX Markets - Unique characteristics
liquidity, trading vol., no. of traders, trading hours, low profit margins (bid-ask spreads) but overall profits may be high due to large volume & use of leverage
Market Segments & Instruments traded - Spot market
For currency deals for immediate delivery/instruments with maturity date within 2 business days after transaction.
Markets Segments & Instruments traded - "Tom", "Tod"
- Tom - transactions settlement tomorrow
- Tod - same-day settlement
Markets Segments & Instruments traded - "forwards & forward swaps"
Involves future delivery of currency at specified future date
Markets Segments & Instruments traded - "Futures & Currency Options"
Deals in contracts to hedge against future changes in FX rates
Markets Segments & Instruments traded - "Swaps - currency swap"
Technique that takes floating-rate debt servicing in one currency (coupon & principal repayments) & hedges the cost in terms of another currency.
FX Basics - Asking For a Quotation - 'you may ask “What is SF NZD spot rate?”'
- Dealer will know that you are asking for spot price of SF1 in terms of NZD
- If you said NZD SF rate, quote will be for price of NZD1 in terms of SF
First currency mentioned is the...
Unit of quotation or base currency
Two Number Quotations (Dealers) - "USD/NZD 1.5044 - 1.5061"
USD/NZD one fifty forty four to sixty one. Note that decimal point is not mentioned & second number is abbreviated to 61
Two Number Quotations (Dealers) - "Kiwi Euro is one-thirteen fifty-two to sixty-eight means"
NZD/EUR 1.1352 - 1.1368
Understanding Foreign Exchange Spot Quotes (bid price, ask price, spread)
Quote: NZD/USD 0.6244 0.6251
- FX dealer 'buys low' and 'sells high'Bid price = buying price. Bank will buy NZD1 for USD 0.6244 (Customer view - sell NZD1, get USD 0.6244)
- Ask (Offer) price = selling price. Bank will sell NZD1 for USD 0.6251 (Customer view - receive NZD1 on payment of USD 0.6251 to dealer)
- Spread = difference for bank or dealer
Quotes - "Commodity" vs. "Terms" - Commodity
Usually one that is expressed as 1
Quotes - "Commodity" vs. "Terms" - Term
The other currency, one that varies in price
Quotes - "So when the term’s currency in the quote..."
- rises ⇒ commodity is dearer
- falls ⇒ commodity has fallen in value
E.g. 1 NZD = 0.4600 USD moves to 0.5000
Rise (appreciation) in the Kiwi
E.g. 1 NZD = 0.4600 USD moves to 0.4500
Fall (depreciation) in the Kiwi
Convention in the FX markets
- Currently, all countries quote to the USD
- Some use it as term’s currency (American) & some use it as commodity (European)
- Commonwealth countries use USD as 'terms currency'
- Other countries - USD 'commodity', express their value as 'terms'
Convention in the FX markets - "direct" and "indirect"
- Direct = local currency price of 1 unit USD, where the USD is unit of the quotation or base currency
- Indirect = is the price of USD of one unit of home currency Where the USD is the terms currency & the other currency is base currency
It is possible to reciprocate quotes & reverse the commodity currency to the term’s currency & vice versa.
- Simply divide the quote into 1
- 1 NZD = USD 0.5000
- So 1 divided by 0.5000 or 1/0.5000
- 1USD = NZD 2.000
Reciprocals for 2-way quotes
- Reverse quote
- Then, take reciprocal
- NZD/EUR 1.2255 1.2265
- Reverse 1.2265 1.2255
- Reciprocal 0.8153 0.8160
Cross Rates - Crossing two direct quotes -e.g. USD/EUR 0.89303 – 08 , USD/JPY 101.921 – 31
- First: divide offer into bid
- Second: divide bid into offer
Cross rates - Crossing direct & an indirect FX quote
GBP/USD 1.31352 – 57
USD/NZD 1.38273 – 78
Cross rates - Crossing two indirect FX quotes
AUD/USD 0.75566 – 73
GBP/USD 1.31386 – 91
FX can be bought or sold for a price determined today but delivery takes place at a predetermined future date
Conventions for quoting the outright forward rate - Example: Ask for spot & 1 month forward- given the Kiwi is fifty one thirty to forty, one -thirty- three to twenty- four
- To determine whether to add/subtract forward points
- - If ascending, then add to the spot rate
- - If descending, then subtract from spot rate
If forward points are falling...
The commodity currency is at a forward discount
If forward points are rising...
The commodity currency is at a forward premium
Conventions for quoting the outright forward rate - Example - Ask for spot & 1 month forward- given the Kiwi is fifty one thirty to forty, one -thirty- three to twenty- four